Emerging Green Values

October 20, 2008

By Fredric B. Prohov
Valuation of real estate is often more of an art than a science. When it comes to assessing the economic value of green buildings, appraisers will have a tough time for a while as they attempt to establish new methods to capture and then quantify the benefits these new types of structures create. There still is an insufficient volume of comparable sales of green buildings and not enough historical data from the higher net operating income they generate to develop wide spread survey studies. While appraisers may hold back the type of traditional valuation reports required by investors and lenders, the case can be made for higher valuations for green buildings than the conventional counterparts. It is becoming obvious that the costs of energy will continue to increase over time. This factor alone will have a greater impact on the choices people make about where, as well as how, they live, work and manage their built environment.

Buildings that provide a higher energy performance level of efficiency will minimize the higher costs of operation and will thus have more value than other buildings that do not perform as well. A building located closer to low-cost, eco-friendly public transportation will also have a competitive advantage.

The demand for high-performance products can be seen in automobiles, batteries, aircraft and equipment as the cost of gasoline has skyrocketed, but buildings consume a major portion of the energy we use for heating, cooling, ventilation and lighting. The entire cost structure of our world demands higher performance buildings. This trend will continue to add pressure to produce a lower carbon footprint as well. Demand for green buildings will remain higher than the supply and the resulting higher values will start to show up in comparable information on sales and lease activity as more and more green buildings emerge. Brokers who have a better understanding of the factors of what makes a building green will be better equipped to sell or lease green real estate in this growing niche market.

The evolution of integrated green design, construction, operation and maintenance programs has been accelerating, but it will take time to dispel the myth that the costs to develop and build green outweigh the benefits they will provide. The cost/benefit analysis still may depend on the length of time one has to obtain for the return, but the environment will always benefit from green building. If there are higher costs for certain green features to be included in a building, a developer faced with a short-term construction loan and a residential product cannot justify any higher expenses. There is a conflict between the shorter time horizon to obtain profit for the developer and the real long-term benefits going largely to his buyers or tenants. These long-term benefits are not measurable in terms of valuation.

As the design/build cost factors go down with experience, the long-term benefits from energy efficiency will become more apparent and will be added to current valuations. For projects undertaken for municipal structures and hospitals, the developer/owner and the user can focus on the longer-term benefits that will be derived from greener projects. Larger commercial buildings also have a larger scale that can take advantage of benefits from additional green features and will be in a better position to capitalize on them. As more green buildings are built, the advantages are being studied and the data demonstrating higher value will emerge.

There are other valuable benefits of a green building, aside from energy efficiency, that can be found on both a monetary and non-monetary basis that are not yet a part of a typical appraisal. Benefits can be direct to an owner/user or indirect to the community in which it is located. Appraisers must professionally demonstrate value founded on facts that can be established with standard methodology from sales comparables, cost factors and an income approach of discounted cash flow analysis. These tools will prove to be too limited to provide the full picture of current market value that must give greater weight to green features. There must be a more accepted concept for valuation to show the projected cost savings from the addition of a geothermal heating and cooling system, for example. As transportation costs go up, increased weight of the value of proximity to public transportation will be necessary. In the near future, policy changes from government mandates for impact fees and incentives with tax credits may weigh in with new legislation to encourage lower carbon emissions, lower storm water runoff or a lower heat island effect from a project development.

Although there is a plethora of “greenwashing” going on, for the moment, a green building is labeled as such because it feeds into one of only two current market brands that have become more prevalent than others: Energy Star and LEED. The EPA established its Energy Star program years ago to rate refrigerators and other appliances, and has since moved on to rate energy-efficient buildings. LEED was established by the United States Green Building Counsel, and has gone from a mere handful of buildings a few years ago to over 7,500 currently working their way through the certification process.

Valuation methodology will have to adapt and change like everything else, but the progress in this area will likely continue to slowly follow, rather than lead the process along. In the meantime, competitive advantages from green buildings will be recognized and higher valuations will be achieved by the early adopters of this type of development.

We live in a complex world, but consumers still move the market. We all seek to live, work and commute in the most cost-effective ways and still have a meaningful life in a healthy environment. Green buildings are in short supply but they serve each of those demands. It is only a matter of time before market forces will lead to higher valuations for green buildings. Accepted methodologies for reporting those captured benefits will also soon be in high demand to provide prospective purchasers, tenants, investors and lenders ways to assess and compare competing products in the marketplace.

Fredric B. Prohov is an attorney practicing in Chicago for nearly 30 years in the areas of real estate and finance, who obtained a LEED AP designation from the USGBC in 2004. You can send your thoughts, comments or questions to him at rprohov@paalaw.com.